ESG loans broaden access to sustainability-linked financing
Not everyone can be Patagonia, the outdoor clothing brand nearly as well known for its environmentalism as its parkas. Many companies want to reduce their negative impacts on the environment, but their business model or industry presents a challenge. Through sustainability-linked loans (aka ESG-linked loans), these companies have access to capital meant to improve their environmental or social impact, and the banks that offer these credit facilities see that as a good thing.
Like green bonds, these corporate loans tie capital to improvements in sustainability, but unlike their older, better-known cousin, ESG-linked loans don’t require a borrower to use the proceeds for a specific, predetermined purpose. (Telecom company Verizon, for example, agreed to use its recent $1 billion green bond to fund a number of projects, including renewable energy, green buildings, sustainable water management, and reforestation efforts in areas hit by natural disasters.) ESG loans fall under the broad category of lending for "general corporate purposes" and can finance virtually anything. Instead of the use of proceeds, it is the credit facility’s interest rate that is linked to improvements in sustainability.
Typically, the bank measures the borrower’s success (or lack thereof) using a benchmark, a rating from a third party such as Sustainalytics. But these loans also can be tied to a clear environmental or social impact target, such as a specific, reduced level of greenhouse gas emissions. The key is that the cost of capital can shift both up and down, based on the company’s score or performance.
"Some companies are not in the position to do a green bond," Davida Heller, senior vice president of corporate sustainability at Citi, told the audience attending a panel on ESG and green loans at last week’s GreenBiz 19 event outside of Phoenix. "With this product, there’s a lot of flexibility."
This flexibility appeals to companies, which have driven the development of the ESG loan market, said Heller and fellow panelist Anne van Riel, head of Americas sustainable finance for ING Capital.
ING issued the first sustainability-linked loan, totaling $1.2 billion, to Dutch electronics company Philips in April 2017, at the company’s request, van Riel told GreenBiz. "It was really a question from the client, ‘Can we do something around our goals without having to issue a green bond?’ Because they didn’t have a specific use of proceeds. Then jointly we came up with this way of tying their performance to, in that case, their Sustainalytics rating. That was how the first one was born."
Philips already had a strong environmental record; however, the idea is not to cater to the Philipses of the world, but to incentivize companies not as far along the path to sustainability to improve. Companies from any industry that the banks lend to, including oil and gas and mining, can obtain one of these loans. In a way, ESG loans represent another front on the divest or engage debate, with the banks that offer them squarely on the engage side.
"Banks are often criticized for the companies they lend to," van Riel said. "But it’s easy to walk away from something. It’s harder to engage and [effect change]."
And these banks are not handing out discounts willy-nilly. The borrowers can’t be laggards; they must have a sustainability policy in place and commit to ambitious, material and measurable targets. "They can’t cherry-pick. An energy company can’t say, ‘We’re measuring our waste,'" van Riel said. "We are very careful. We’re limiting ourselves to companies that are taking sustainability seriously."
Sustainability-linked loans reached $36.4 billion globally in 2018, according to BloombergNEF. The loans account for just a small piece of the broader sustainable finance market, which hit a record-setting total of $247 billion last year, an increase of 26 percent. Green bonds issuance accounted for the bulk of that, $182.2 billion, in a category that also includes social impact bonds, green loans and a number of other instruments.
Green loans represent another new tool in the sustainable finance toolbox — the Loan Market Association rolled out the Green Bond Principles (PDF) last year — although sustainability wise, they are structured more like a green or social-impact bond than an ESG-linked loan, with the borrower committing to an intended use of proceeds.
In Europe, where the ESG-linked loan market is more developed, the borrower typically receives a 5 to 10 percent discount on the interest rate depending on the cost of capital. In other words, the higher the overall rate, the larger the discount.
In the United States, where the market is still quite nascent, the range is lower, Heller said.
CMS Energy was the first U.S. company to receive an ESG-linked loan, in June. The $1.4 billion credit facility allows the Michigan-based company, which has committed to eliminate its coal-powered energy production by 2040, to reduce the interest rate on its loan by meeting targets related renewable energy generation.
"Even if you’re in a medium- to high-risk sector, you can have sustainability goals," Heller said. "And if these loans are a tool that helps you get there or establish more ambitious targets, we want to support that."
With what amounts to banks giving up revenue today for a clients’ improved long-term sustainability, ESG-linked loans are another sign that the financial industry considers ESG performance an indicator of future risk, Heller and van Riel agree.
"For us, it’s about the companies we want to be involved with 10 years from now," van Riel said. "If they are taking their sustainability performance seriously, and they manage their risk well, we believe the finance risk is reduced. And these are the companies we want to bank and the relationships we want to have in the future."
A previous version of this article stated that the discount a borrower of ESG loans receives in the U.S. was two to five percent. This number referred to a different measurement of financial discounts. The article has been updated to reflect the accurate number.